From long-term structural trends to current market conditions,
Nelson lays out
an ugly picture for hedge funds that he thinks will end with
a massive shrinking of the industry.

"So what’s the bottom line of these changing industry dynamics?"
Nelson wrote.

"I believe there will be a culling of hedge funds like
we've never seen before. I'd estimate the number of funds gets
cut in half over the next couple of years."

Thus, the title of Nelson's commentary: "The Hedge Fund
Apocalypse."

It all comes down to performance

Nelson, whose fund manages $8.4 billion in assets, argues that
hedge funds' biggest problem is performance, or
more accurately the lack thereof. Nelson said all of the
issues "start and end here," noting that hedge funds had "gotten
trounced by plain vanilla investments" since 2008.

In fact, the HFRX global hedge fund composite is down 1.19% over
the past five years, while the S&P 500 is up 11.02%, the
Barclays US bond aggregate is up 3.60%, and a classic 60/40 mix
of stocks and bonds is up 8.20%, according to Nelson.

This lackluster performance is an even bigger problem given
investors' increasing impatience.

"Further, this underperformance is magnified in today's
marketplace, where investors are irritated after a bad quarter …
or month … or week," Nelson wrote. "The idea of investing over a
market cycle is increasingly a foreign one."

There are other places for investors to go

In past cycles, a few years of underperformance would no doubt be
a problem for hedge funds, but there was some sense that
investors had no other place to go for the kinds of strategies
the funds were providing.

Now, Nelson said, there are plenty of other avenues for investors
that offer not only the same types of strategies, but also better
returns in today's market along with lower costs.

"There are a number of commodity, currency and credit funds to
now choose from in ETF and mutual fund vehicles," Nelson said.

"Moreover, there are a number of daily liquidity funds that run
the hedge strategies themselves. This gives investors the option
to tactically move in and out of exposures that previously they
often had to access through hedge funds."

This is similar to commentary
we have heard from other funds. Highland Capital chief
investment officer Mark Okada has said
liquid alternatives, similar to hedge funds but with the
ability to move money in and out on a daily basis, will be as
disruptive to the industry as Uber has been to taxis.

Nelson in fact mentioned that many institutional investors such
as pension funds and
insurance companies were already quickly reallocating away
from hedge funds.

"After years of inaction, the tide is now changing fast on this
front," Nelson said. "Whether driven by their own decision making
or their clients', the institutional consultant community
is under severe pressure to justify the presence of hedge funds
in client portfolios."

To be fair, Nelson's firm provides liquid alternatives, putting
him in competition with the hedge funds he is discussing, but he
acknowledges that
even liquid alts are getting hurt by the shift as many
investors are moving to private equity or basic portfolios.

The issue for both hedge funds and Nelson's firm is that with so
many options it becomes easier for large investors to move money
to the best-performing investment type.

It will get ugly

"There will be a new push for lower fees, similar to the one that
took average fees from 2 & 20 to 1.5 & 15 several years
ago," he said in the commentary.

The move to investment vehicles with lower fees is
a more secular trend and is certainly
not limited to hedge funds. But the push for lower fees from
the aforementioned alternatives will hit the income of funds that
are already struggling to make gains in the market.

Add together the miserable performance, readily available
alternatives, lower fees, and restless investors, and you've got
a tough road for the hedge fund industry.